This morning Bloomberg reported that Abercrombie & Fitch (ANF) CEO Michael Jefferies—who has led the retailer for nearly two decades—has announced that he intends to sell as much as 1.79 million of his shares.  At current market value, a sale of that magnitude would net him nearly $63 million pre tax.  This appears to be a similar move to Ralph Lauren’s recent announcement of a major share sale in Polo Ralph Lauren (RL), and with capital gains taxes likely on the rise, these sales could potentially save millions in capital gains taxes.

Apparently, Mr. Jefferies is undeterred by an investigation by an executive compensation watchdog group, The Shareholders Foundation, on behalf of long term shareholders.  They claim that ANF’s management compensation has been excessive and has breached their fiduciary responsibilities.  At Ockham, we are not shareholders of ANF nor do we know whether or not the investigation has merit or will lead to legal action, but it does at least demonstrate some level of dissatisfaction between shareholders and management performance.  Their press release states,

While Abercrombie & Fitch Co. reported decreasing revenue and decreasing Net Income along with experiencing lower stock value, its CEO Michael S Jeffries, who runs the label since 1992, received in 2008 a 5year Compensation Total of $184.87 mil, or an average of almost $37million per year. In April 2010 Abercrombie & Fitch Co. announced in a SEC filing that it entered into an amendment to the employment agreement with its CEO Michael Jeffries to limit his unlimited personal use of Company aircraft. Previously, Mr. Jeffries was entitled to unlimited personal use. From 2006 to 2008, he booked an average of about $850,000 a year worth of personal travel on the corporate jet. In 2008 alone, he tallied roughly $1.1 million worth of personal travel on the jet. In exchange for agreeing to the limitations, Mr. Jeffries will receive a lump-sum payment of $4 million from Abercrombie & Fitch Co. In May 2010, Abercrombie and Fitch announced that the Fiscal 2009 total compensation for Mr. Jeffries was $36.3million. — Shareholders Foundation Press Release regarding investigation 8/23/2010

The investigation notwithstanding, avoiding increased tax rates is a sensible move for these CEOs, and we do not want to read too deeply into such a sale.  In fact, we expect to hear of more executives selling to avoid future tax consequences.  However, there are other reasons for current shareholders to consider following the executives lead in the case of Abercrombie.

First, recent actions by ANF management suggest that they are cautious about their ability to grow domestically.  In their most recent quarterly report, they announced intentions to close 60 stores before the end of the fiscal year in January.  There are plans to add stores domestically, including their first location in Puerto Rico, but planned openings amount to only 16 stores total among Abercrombie, Hollister, and all other labels.  Management continues to say that international sales will drive growth, and those sales have increased 85% in the last year.  However, Abercrombie only gets 15% of its sales from overseas, which pales in comparison to the seemingly saturated US market.

Execution was also fairly weak in the last quarter.  The company was able to show improvement over last year’s result because quite honestly last year was horrendous for ANF.  In the last quarter, ANF was one of the few retailers to report declines in gross margin due to lower prices and heavy promotions.  Furthermore, inventory at stores grew drastically compared to a year ago and is up 54% versus just six months ago.  Inefficient inventory management is a killer of profit margins in retail and something that we pay close attention to.

Additionally, we are concerned over the fundamental valuation of Abercrombie & Fitch.  It is obvious that fundamentals such as revenue and cash earnings have improved from a year ago.  However, according to our methodology, the stock is still too expensive give the current fundamentals.  For example, over the last ten years ANF has historically traded at a price-to-cash earnings level of between 9.4x and 20.6x, but the current price-to-cash earnings multiple is greater than 30x.  To be fair, price-to-sales per share is currently within the historical valuation range, but it remains to be seen how sales will do after net closings of 44 US stores through the end of the fiscal year.

In closing, we doubt that the CEOs stock sale has much to do with his view of the company going forward, and is most likely do to external factors.   However, at Ockham we have an Overvalued stance on ANF at the current price level.  We may raise our view of this stock to Fairly Valued or neutral if they can continue to quickly grow fundamentals or if the price were to fall into the high $20’s given current fundamentals.